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Overoptimism and Subprime Mortgages

posted by Paige Marta Skiba and Jeremy Tobacman

Beyond all the news on the causes of, and policy responses to the current US economic crisis focusing almost solely on financial markets, it's worth paying more attention to causes and policy responses for households.  One household-level cause fits with the implications of a host of other evidence about credit choices: consumer overoptimism.

While recent work has explored overoptimism in several markets already, including credit cards, payday loans and health-club contracts, overoptimism seems particularly relevant to understanding household behavior in mortgage markets. Households could have believed home prices would continue an inexorable rise. Households might have anticipated that they'd have lower expenses or be able to earn additional income over time. They also could have hoped interest rates would fall, facilitating mortgage refinancing or home resale before payments on their mortgages rose.

Lenders have complicated incentives in relation to borrowers' overoptimism.  Lenders would wish to
cultivate overoptimism to the extent that it increases demand for loans and decreases interest-rate sensitivity. To the extent that overoptimism increases delinquency and default rates, lenders would want to disabuse borrowers of it. Mortgage lenders' incentives to counteract borrowers' overoptimism shrunk over the last decade, as lenders also began to believe house prices would continue to rise, and as they increasingly sold off their mortgage default risk using mortgage-backed securities.

The resulting costs for households are large. Moving costs for families amount to 10% of the transaction price of a house. Delinquencies and foreclosures compromise the credit ratings of borrowers.  And inefficiencies may be a result: either non-overoptimistic mortgage borrowers should have owned instead of overoptimistic borrowers, or new homes bought by overoptimistic borrowers should not have been built in the first place.

These thoughts lead of course to the question, "So what?" 

Decisions about what to do right now will be influenced by a host of factors, election-year politics not least among them. Government or NGO payments for some homeowners of a bit of mortgage principal might suffice to keep them in their homes. Encouraging financial institutions to renegotiate some mortgages might also help. For the future, the mortgage application process should be required to entail detailed analysis of cash flow for prospective home buyers, to help them think through-- less overoptimstically, and more clear-sightedly--the long path of payments that will gradually turn them into full owners of their homes.

Comments

More information will not debias consumers adequately in the context of the US mortgage market. Lenders are too sophisticated about exploiting the well-understood payment heuristic (relying on monthly payment as proxy for price), overconfidence bias and hyperbolic discounting. What is needed are sensible default products, and regulation that constrains the availability of unsafe choices, for example by banning prepayment penalties and negative amortization except for very sophisticated homeowners. The default product should be the fully amortizing fixed rate mortgage, the home affordability product that was created not by the unregulated market, but by the Homeowners Loan Corporation and the FHA in the 1930s, then copied by private lenders. Lauren Willis has written an excellent paper on this recently, and I have posted my own views on the subject in Behavior and Contract.

I hate that more than anything. When someone goes to finance a vehicle or home the broker will not ask "how much do you want to borrow?" or "Can you afford to borrow X amount?" they ask "What do you want your payment to be?".

If subprime borrowers went with FHA loans they would have been more likely to afford the Mortgage payments, on the other hand their selection would have been severely limited. The seller if given a choice (in a sellers market) between a "conventional loan" home buyer and a home buyer whom the government was looking out for would have chosen the conventional loan home buyer. Even on most mortgage lending companies "hold messages" they would guarantee that a conventional loan will close by the closing date. They had a qualifying message though for FHA or HUD backed home loans.. It was easier to get the risky product than to get a safer one and you were more likely to close on time with what we know now were risky home loans. It was all backwards..... (my op.)

The only thing I'd like to amend in what you said, Patches, is "if subprime borrowers were given the OPTION of going with an FHA loan." More and more, I'm hearing that borrowers were steered away from conventional fixed rate loans - if they were offered them to begin with - simply because of the greater profit of other more exotic loans (ARMS, interest-onlys etc.)made by the broker.

There, again, is that word - "broker". Third party, no skin on the game once the loan is closed. I wonder if there are any numbers out there to show the number of default/foreclosures as they pertain to local community banks/credit unions who keep their loans and servicing in-house vs. large brokerage initiated/national bank loans...

Great Point! Now that I think about it (because of your comment Mike), I do not see as many foreclosures on homes (in bankruptcy) financed by local Credit Unions and local banks. The vast majority, locally anyway are "Countrywide" "Vanderbilt" and the Majors. It is a rare thing to see FHA's in bankruptcy nowadays. I don't know if it’s because not as many were written or that the loans they back are more feasible. (Both I guess??)

Don't know if its a numbers game in that "locals" do not write as many loans or the fact that their underwriting policies are more ridged as I assume they are. Again it could be both.

I definitely have not seen any "No doc"/"liar loans" AKA "Alt A" written by local Banks and CU's. There might be but I haven't seen them in bankruptcy anyway. I assume that if there are those "No Doc" loans written by "locals" they might be crossed with another form of collateral. ie…. CD's.

I'd be willing to bet that it's a combination of more stringent lending policies of locals/CUs and, assuming that most local/CU loans are kept "in-house", a lack of securitization.

I'd be interested to see what Professor Porter's data showed with regard to the number of loans that contained fraud a.) How many of those loans were securutized b.) How many of those loans were made by national banks/brokers vs. locals/CUs c.) of the loans with fraud, the number of loans with ORIGINATOIN fraud vs. SECURITIZATION fraud and d.) How many of the overall loans (1700+ if I remember) had been securitized.

I like Professor Porter's take on things. One of her papers was included in a packet put together by the local bar assoc. I didn't get to GO! I told boss "Its cool, I read and blog with her on Credit Slips" and I had already got her take on Proofs of Claims in BK and Servicers misdeeds.

Unfortunately for me I’m up to my ears in POC's and objecting to everything practically! Lose lips make for more work around here. Dang! I am excited to put some of her concepts to work though. Servicers hide in the volume of accounts they service. May be we can turn that around a bit and make it work to our debtors advantage.

If you are reading, Thanks Katie! (Heart felt and sarcastically at the same time)

Mike:

The whole steering from FHA into subprime argument is not as cut and dry as the media would have you believe. Most of the people who make this argument know absolutely nothing about the mortgage market. First, FHA loans pay more than almost any loan product, even the dreaded option arm. FHA pays up to 4% of the loan amount in commission at very competitive rates. So why would a broker steer someone out of an FHA loan that they can make 4% on at a very competitive rate into a subprime mortgage that has substantially higher interest rates and pays very little commission? They wouldn't. Yes, sub prime loans didn't pay very much in commission by way of yield spread premiums. In fact, sub prime paid even less than conforming mortgages too! No broker would purposely put someone in a higher cost product to make less money. Makes absolutely no sense. The vast majority of consumers who got these loans did so because there was no other loan product available for them.

FHA loans were not used for a number of reasons. The first is that all brokers didn't have access to the loan product because in order to originate FHA loans, you have to pass a very cumbersome and expensive audit. For many smaller brokers who did not do a lot of FHA deals, the expense was not worth it. Second, FHA loans require a three percent down payment. Many borrowers when given a choice of coming up with 3% down would rather take a subprime loan at a higher interest rate with no down payment. This is just a reality of dealing with middle america. Newsflash: 90% of the public aren't as smart or rational as the people that read this blog. One of my co-workers specialized in FHA and used to complain all the time about consumers not wanting the FHA simply because it required them to come up with a few grand for a down payment. Third, FHA loan amount restrictions made them difficult to do in many higher cost of living cities. Here in Chicago it was damn near impossible to do an FHA loan when the loan cap was $247k. That could barely get you a 1 bedroom condo. Finally, FHA does have more stringent guidelines in some areas, but they are more liberal in others. FHA loan default rates are actually quite high as the typical FHA borrower is not usually the most credit worthy either.

Well gee...THANKS Russ... NOW you've got me wondering why I wasn't able to get into an FHA fixed back in '01...OR '99... That's going to fester awhile.... ;)

In all seriousness, thank you. I haven't heard anyone talk about comm rates between FHAs and "other" loan products until now... NOW I'm wondering just how much access was limited because borrowers were going through the smaller shops...Like myself...

As one of the evil mortgage brokers, I am just getting a little annoyed with all the broker bashing in the media and by consumer groups and politicians. Especially when the information presented is completely false or done in a misleading manner.

You may not have gotten an FHA loan for any number of reasons. It is really hard to say. In many cases, borrowers just qualified for better conforming loan products. However, FHA should have definitely been preferred over a typical 2/28 sub prime arm when possible. But like I said, there are many reasons why borrowers get put in subprime loans. In most cases it is because there is something about their file that prevents them from qualifying - too high of debt ratios, 100% financing, or just really really bad credit. HEck, FHA loans can be a pain to use to finance condos. However, to make more commission is not really one of them because FHA pays the most on average (by like 2-3x's) of ANY mortgage product.

What media fails to report is that a large percentage of subprime mortgages are REFINANCES, not home purchases. People withdrawing equity to buy boats, cars and flat screen TVs and other crap. A lot of the subprime lending probably kept foreclosures artificially low for a few years which is why we see the spike we have now. Every story I read with some crying "victim" shows where someone got a subprime loan as a refinance to get cash out of their house because they were having financial problems. Of course, the reporter fails to mention that the fact they got the loan probably kept them in the house several years longer until finally their issues, job instability, drug habit or whatever caught up with them. Now that home values are stagnant and the loan products gone, these people can't simply refinance themselves out of trouble again.

I will have to post the link when I find it again, but I saw a presentation that showed less than 2% of countrywide's defaults are the result of an ARM adjusting, yet all we hear about is these dangerous sub prime ARMs. People lose their homes because they lose their jobs or have other issues. The other thing the media doesn't report is that close to half of the foreclosures right now are INVESTORS. Basically, all these chumps you see on HGTV trying to flip houses after throwing a coat of paint on the walls. This so called foreclosure crisis is nothing but the same jokers who thought they could make millions day trading during the dotcom boom thinking they could also make millions during the real estate boom hence why the bulk of the foreclosures are in CA, FL, NV, and AZ. The other states with high foreclosures are arm pits of a failing manufacturing economy - michigan, ohio, indiana, etc.

Enough ranting... I feel like I am pissin in the wind nowadays with all the screaming from these so called consumer groups and politicians. Facts... who needs facts anymore? Let's just pass some feel good legislation and make people believe their woes are the fault of the big bad banks. Years ago everyone was assailing the banks for not lending to people with less than stellar credit. The banks lend high risk borrowers money and of course they go into default and everyone screams that the banks shouldn't have lent them money. Good grief.

Oh, don't get me wrong, Russ. I know there is enough blame to go around for everyone in the circle. Lenders created it, brokers distributed it and borrowers bought it. Sounds surprisingly similar to coke distribution only with LEGAL cartels handling the product. There are good/bad examples at every level of this thing.

The problem I have is when the table gets tilted in the direction of the entities who, if they played the game "honorably", would have still made a pile of money - it just would have been a smaller pile.

If enough people in the lending chain each bend the rules a bit sooner or later the rules are going to come over the top and start poking them from behind.

Do we need more "feel good legislation" to save the - what - roughly 4% of true homeowners and/or legitimate speculators that are going to be wiped out because of legitimate market moves? No. Unfortunately, that's the way the market goes. That's why real estate, including home ownership is called an "investment".

What we DO need is effective legislation that closes as many loop holes as possible so that greed infected trustees, sellers, depositors, RMBS securitizers, lenders, brokers, investors, speculators, and homeowners are properly culled from the equation. Notice that I DID put the homeowner - the *legitimate homeowner* - at the bottom of this list. That is partially due to the fact that everyone else on that list has or has easier access to more information than the average homeowner.

What we REALLY need is accurate ENFORCEMENT of CURRENT rules and regulations. That simply is not happening. And until that DOES happen, and the financial incentive no longer outweighs the legal and/or financial risk for EVERYONE involved, these problems simply are not going to go away.

Great point’s guys! Russ you should post more. Although we are on completely different sides of the equation Russ, I think we need to hear more from your side. Don't get mad, both sides can benefit from our discussions here. Mike, you and I always seem to be on the same page.

Now on our local bankruptcy front, I used to see FHA homes in chapter 13 quite often say back in 96-01 but since 01 I have been seeing them less and less. Be it market share or debtors being able to work out things better with FHA or HUD when they get behind,whatever. In fact I seem to remember FHA or HUD foreclosures being a rare thing because of the pains they went thru to keep debtors in their homes. Even then they would let them rent after foreclosure.

Anyway.... what I'm not cool with was the practice of mandating that debtors pay off unsecured debts even if they were uncollectable in order to be approved for a home equity or refi. Home equity part doesn't bother me that much but on a refi? NO! In Texas the wording in our Constitution says that a lender cannot require that of the debtor but subsequent case law seems to suggest otherwise. That’s what I am seeing a lot of. I have to shake my head and wonder why? "Lower your total monthly payments". It sounds great until you see it from my point of view. You just amortized $10k in credit card debt over 30 YEARS!???! But the interest rate is lower and I'm saving my credit. But look at how much you are borrowing! In Texas it almost makes no sense aside from saving or improving credit because Homesteads are protected from forced sale by unsecured creditors, even abstract judgments are voidable when it comes to Homesteads.

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